There’s a Right Way and a Wrong Way to Consider Past Performance

In light of the record-breaking returns that many mutual funds posted last year--171 delivered gains of 100% or more--the Securities and Exchange Commission did something last week that it rarely does: It passed along some investment advice.

It warned investors not to rely too much on the rearview mirror when picking mutual funds this year.

“Chasing past performance is often the quickest way to hurt your mutual fund returns,” SEC Chairman Arthur Levitt said.

This is timely advice. As it happens, a number of 1999’s best performers have lost money so far this year, and some of 1999’s laggards have posted double-digit gains since Jan. 1.

But it raises a question: If you can’t rely on past performance to pick new funds, what can you rely on?

The truth of the matter is, past performance has a place among the several attributes you should study in evaluating which funds to buy. The trick is to know which measures of past performance to consider in a given situation, and how much weight to give them.

The key is not to fixate on the absolute best short-term return numbers in a particular category of funds. Instead, concentrate on funds that have demonstrated consistency of performance over at least the last three years, analysts say.

Beyond that, the following measures of fund quality, composition and cost can help you in evaluating choices:

* Sharpe ratio. Standard & Poor’s Fund Services relies on this mathematical calculation, developed by Stanford professor of finance William Sharpe, to come up with its “Select List” of recommended funds.

In layman’s terms, the Sharpe ratio measures how much reward an asset delivers per unit of risk. The higher the ratio, the better the investment.

The typical stock fund sports a Sharpe ratio of 0.63, according to fund tracker Morningstar Inc.

Say you want to buy a small-cap growth fund. The average Sharpe ratio for this category is 0.58, according to Morningstar. Had you screened for small growth funds with a significantly higher Sharpe ratio, say 1.0, at the start of 1999, you would have ended up with a list of what turned out to be some of last year’s best performers--such as Janus Venture, which gained 152% in 1999, and RS Emerging Growth, which returned 182.5%.

The predictive powers of the Sharpe ratio are debatable, because it is based on historical (that is, past) risk and return data. But at the very least, it should keep you away from the dogs, says Philip Edwards, managing director for S&P; Fund Services in New York.

To find a fund’s Sharpe ratio for free, go to Morningstar’s site, https://www.morningstar.com. Type in the name of the fund in the box on the upper left corner of the page. Once the fund’s page comes up, click on the tab labeled “Ratings and Risk.” The Sharpe ratio will be shown on that screen.

If you are a “premium member” of Morningstar’s site (the charge: $9.95 a month or $99 a year), you can screen for funds in a variety of categories based on Sharpe ratio.

* R-squared. If you’re looking to diversify your holdings, this statistic can come in handy.

Say you own the Vanguard 500 Index fund, which tracks the Standard & Poor’s 500 index of blue-chip stocks, in your 401(k). Let’s suppose you’re looking to invest in a second domestic stock fund in your 401(k) and that you have two other choices in your company-sponsored retirement plan--Fidelity Growth & Income and Fidelity Growth Company fund. Which do you choose?

Check out the funds’ R-squared, a figure many funds list in their shareholder reports, or that you can find on Morningstar’s Web site. R-squared tells you how much the fund’s performance correlates with the movements of the S&P; 500. The higher the R-squared--it runs from 1 to 100--the closer the fund’s performance will resemble the S&P; 500’s. It should be noted that sometimes there’ll be a second R-squared that measures the fund’s correlation to a different, more appropriate market benchmark--say, the Russell 2000 index for a small-company fund.

In our example, both the Growth & Income and Growth Company funds invest in shares of large companies. And both have top, five-star risk-reward ratings from Morningstar. But Growth & Income has an R-squared of 97, just 3 points off the Vanguard 500’s R-squared of 100. Growth Company’s R-squared, on the other hand, is 68.

If it’s diversification you want, then Growth Company may be the better choice.

* Price-to-earnings ratio. In this go-go era of growth-stock investing, fewer and fewer investors care about a stock’s price-to-earnings ratio, says Russel Kinnel, equity editor for Morningstar. P/E, a valuation measure, is a stock’s market price divided by the underlying company’s per-share earnings over a 12-month period. The higher the ratio, the more an investor is paying for that company’s earnings.

Kinnel recommends that investors consider the average P/E of a fund’s holdings before jumping in.

“A lot of the best-performing funds have average P/Es in the 50s,” he says, well above the average P/E of 28.7 for the S&P; 500, based on the last 12 months’ earnings. “Obviously, there’s a lot of price risk in those situations.”

You can look up the average P/E of a fund’s portfolio for free on Morningstar’s Web site. Click on the tab labeled “Portfolio.” Be aware, though, that these figures may not reflect recent changes to the fund’s holdings.

* Portfolio concentration. How many stocks does a fund own? “Does it have 20 or 120?” says Kinnel. “If it owns 20, it will give you a much more turbulent ride.”

This information can be useful in knowing what to expect. If you’re after safety, then you’d want a fund with a broader portfolio. But if you’ve got money to gamble, volatility be damned, then you might look for high returns with a concentrated fund.

This information also can be found on Morningstar’s site. But, again, the data can lag by weeks or months.

* Expenses. “So much of what you’re evaluating in a fund carries a high degree of uncertainty,” notes Steve Savage, editor of the No-Load Fund Analyst newsletter in Orinda, Calif. Not so expenses.

“Scrutinize the fund’s sales charges, fees and expenses,” the SEC added in its warning last week.

There is absolute certainty that a fund with an expense ratio of 0.19% will take a modest 0.19% of your assets (including gains) every year, and that one with a ratio of 2.19% will take a lot more.

A fund’s expense ratio can be found by calling the fund company, in fund literature, or at the fund company’s Web site.

* Intangibles. When the No-Load Fund Analyst searches for good funds, “we look for good performance records that are likely to be sustainable,” Savage says. The newsletter staff does this by talking with fund managers to learn whether their investing strategies are disciplined and well-thought-out.

Until recently, most fund investors haven’t had access to such analysis--at least, not for free. But today there are a few places to look.

One is at https://www.standardandpoors.com/onfunds. There you can check to see if your fund made S&P;’s Select List of recommended funds. If it’s on this list, you can get a free report written by S&P; analysts.

Morningstar’s site offers a brief analysis of a fund for free, and more lengthy write-ups are available for a fee.

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Do you have ideas for mutual fund and 401(k) topics for this column? Times staff writer Paul J. Lim can be reached at paul.lim@latimes.com.